Brokers threatened by run on shadow bank system

AlistairBarr

SAN FRANCISCO (MarketWatch) -- A network of lenders, brokers and opaque financing vehicles outside traditional banking that ballooned during the bull market now is under siege as regulators threaten a crackdown on the so-called shadow banking system.

Big brokerage firms like Goldman Sachs
GS, -0.73%
Lehman Brothers
LEH
Morgan Stanley
MS, -0.86%
and Merrill Lynch
MER, -0.53%
which some say are the biggest players in this non-bank financial network, may have the most to lose from stricter regulation.

The shadow banking system grew rapidly during the past decade, accumulating more than $10 trillion in assets by early 2007. That made it roughly the same size as the traditional banking system, according to the Federal Reserve.

While this system became a huge and vital source of money to fuel the U.S. economy, the subprime mortgage crisis and ensuing credit crunch exposed a major flaw. Unlike regulated banks, which can borrow directly from the government and have federally insured customer deposits, the shadow system didn't have reliable access to short-term borrowing during times of stress.

Unless radical changes are made to bring this shadow network under an updated regulatory umbrella, the current crisis may be just a gust compared to the storm that would follow a collapse of the global financial system, experts warn.

Such vulnerability helped transform what may have been an uncomfortable correction in credit markets into the worst global credit crunch in more than a decade as monetary policymakers and regulators struggled to contain the damage.

Unless radical changes are made to bring this shadow network under an updated regulatory umbrella, the current crisis may be just a gust compared to the storm that would follow a collapse of the global financial system, experts warn.

"The shadow banking system model as practiced in recent years has been discredited," Ramin Toloui, executive vice president at bond investment giant Pimco, said.

'Clarion call'

"The bright new financial system -- for all its talented participants, for all its rich rewards -- has failed the test of the market place," Paul Volcker, former chairman of the Federal Reserve, said during a speech in April. "It all adds up to a clarion call for an effective response."

Two months later, Timothy Geithner, president of the Federal Reserve Bank of New York, and others have begun to answer that call.

"The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system," he warned in a speech last week. That "made the crisis more difficult to manage."

On Thursday, Treasury Secretary and former Goldman Chief Executive Henry Paulson said the Fed should be given the authority to collect information from large complex financial institutions and intervene if necessary to stabilize future crises. Regulators should also have a clear way of taking over and closing a failed brokerage firm, he added. See full story.

Banking bedrock

The bedrock of traditional banking is borrowing money over the short term from customers who deposit savings in accounts and then lending it back out as mortgages and other higher-yielding loans over longer periods.

The owners of banks are required by regulators to invest some of their own money and reinvest some of the profit to keep an extra level of money in reserve in case the business suffers losses on some of its loans. That ensures that there's still enough money to repay all depositors after such losses.

In recent decades, lots of new businesses and investment vehicles have evolved that do the same thing, but outside the purview of traditional banking regulation.

Instead of getting money from depositors, these financial intermediaries often borrow by selling commercial paper, which is a type of short-term loan that has to be re-financed over and over again. And rather than offering home loans, these entities buy mortgage-backed securities and other more complex securities.

A $10 trillion shadow

By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007.

Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.

While acting like banks, these shadow banking entities weren't subject to the same supervision, so they didn't hold as much capital to cushion against potential losses. When subprime mortgage losses started last year, their sources of short-term financing dried up.

"These things act like banks, but they're not," James Hamilton, professor of economics at the University of California, San Diego, said. "The fundamental inadequacy of their own capital caused these problems."

Big brokers targeted

Geithner said the most fundamental reform that's needed is to regulate big brokerage firms and global banks under a unified system with stronger supervision and "appropriate" requirements for capital and liquidity.

Financial institutions should be persuaded to keep strong capital cushions and more liquid assets during periods of calm in the market, he explained, noting that's the best way to limit the damage during a crisis.

At a minimum, major investment banks and brokerage firms should adhere to similar rules on capital, liquidity and risk management as commercial banks, Sheila Bair, chairman of the Federal Deposit Insurance Corp., said on Wednesday.

"It makes sense to extend some form of greater prudential regulation to investment banks," she said.

Separation dwindled

After the stock market crash of 1929, the U.S. Congress passed laws that separated commercial banks from investment banks.

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